## Vector Error Correction and VAR Models

Consider two time-series variables, yt and xt. Generalizing the discussion about dynamic relationships in chapter 9 to these two interrelated variables yield a system of equations:

yt =віо + Piiyt-i + ві2Х*-і + (13.1)

xt =в20 + ^2iyt-1 + ^22Xt-1 + Vе (13.2)

The equations describe a system in which each variable is a function of its own lag, and the lag of the other variable in the system. Together the equations constitute a system known as a vector autoregression (VAR). In this example, since the maximum lag is of order one, we have a VAR(1).

Ayt =6...

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